"Rising costs set to bite diners".  Forget the $40 course at restaurants, gentle readers, rising costs of food are causing real hardship across a lot of Australia.

Coming on top of rising interest rates and rising petrol prices, many Australians are feeling the pinch.

Can we sort out cause and effect here?

We have written many times before about the effect of too much money chasing too few goods.

And also that inflation is a global phenomenon. (Note this 1973 article as a first bite - original in its day.)

Of course, in the real world "goods" are not a single item.  Also there are assets as well as goods to spend money on.  This point has been especially important in recent years.  Each country is (imperfectly) connected in many markets to other economies. The net result is that the effect of too much money can be difficult to sort out.

The prices of "goods" or "goods and services" (measured by an index such as the consumer price index) has until recently been held down by the rapid development of China, India and other "emerging nations."

There has been too much money - essentially led by cash rates at a too low 1 % in the US economy, but too easy in most nations, including Australia.

But the China-India-emerging nation developments have held down the prices of goods and services so the excess money has mainly forced up asset prices.

Asset prices are not just influenced by the money supply, of course.  Asset prices are also influenced by the supply of and demand for assets, and very recently asset demand has been depressed by battered investor sentiment.

Partly this is a consequence of tighter monetary policy, but readers will immediately realise that sharp rises in asset prices can "overshoot" - indeed, economists see "overshooting" as an inevitable characteristic of asset markets.

Once asset prices have "overshot", the stage is set for reversal.  We are experiencing such a reversal now, with greatly increased volatility in financial markets but net falls in asset prices.

If the price of assets plunge because sentiment about asset prices is depressed, to the extent there is excess money still in the system, goods and services inflation will rise.

This seems to be what is happening now.  Goods and services inflation is up in almost every nation as excess money now raises goods and services price inflation rather than asset prices as it was while investor sentiment was strong.

As noted, "goods and services" are not a single "thing" with a single price.  They are many, many things.  The price of each thing is influenced by particular factors - eg drought or flood influences the price of bananas, general food shortages increase the price of food, geopolitical tensions influence the price of oil, attempts to control the economy influences the price of money, etc, etc.

Given all the myriad of factors, including investor sentiment, that influence the supplies of and demands for all available assets, goods and services in all nations, it is not surprising that the overall effects of changes in monetary policies are hard to sort out.

Economic models are far from perfect for one nation, but there are many regions and nations with (imperfect) economic interconnections far too complex for anyone to unravel.

Hence Adam Smith's famous "invisible hand" analogy.

But here's the rub.

If factors particular to particular markets force some prices up either other prices must fall or the overall level of prices must rise - the latter outcome is defined as "inflation".

In theory a wise and benevolent central bank can keep strict control of the money supply so that average prices do not change - ie inflation is zero on average.  This in practice is a far from perfect science, so mistakes occur, as occurred leading up to the current global inflation of average goods and service prices.  But there is a deeper problem.

The process of inflation works less smoothly in reverse, when deflation is required.  The most famous example is probably UK in the 1920s.  During the First World War Britain abandoned the so called "gold standard."  Churchill (the "Chancellor" of his time) in 1924 returned Britain to the gold standard at the pre-war value of sterling in relation to gold.  But in the meantime many prices had risen, including in particular the prices (wages) of various classes of British Labor.

To restore full employment, wages (and many other prices) would have had to fall but these prices refused to fall, or fell only slowly.  The net result was economic depression, high unemployment and many severely disadvantaged families whose bread-winners were unemployed.

Recognition of the "stickiness" of many wages and prices, especially in a downward direction, led the economics profession to develop a bias for mild inflation.  Australia's "target range" for inflation is 2 to 3 %, partly in recognition of the effect of sticky prices (and partly because of the more technical matter that existing measures of goods and services inflation are believed to understate effects of improvements in the average quality of goods and services).

Mild goods and services inflation is widely believed to be the best outcome.  But inflation is influenced by the expectations of people as well as the objective setting of monetary policy.  Most people can immediately grasp that too loose monetary policy might lead to inflation, and some people seeing loose money immediately adjust their expectations about inflation and this leads almost immediately to greater inflation. This double whammy is likely to intensify as public discussion of inflation, including newspaper reference to inflationary expectations, gains popularity.

In practice, mild inflation often turns into serious inflation.  Serious inflation is very damaging.

The risks of this are especially high when particular special factors are raising sharply the prices of some goods and services - such as food, petrol and interest rates at present.

For the central bank to keep overall inflation "mild" it must keep monetary policy firm and rely on this to force down sharply the prices of other goods and services, or indeed, of assets.

Owners of other goods and services, or assets, resist price falls and complain loudly to the government. So do - and with greater cause - those people suffering from the direct effect of rising prices of food, petrol and interest rates.

All this is why Australian economic policy, and especially monetary policy, is in such an interesting state.

Ed: Henry Thornton has built on this article to produce his seminal piece "Should the Reserve drop inflation targeting?", published on 25 April 2008 in The Australian. (The battle for ideas is fierce here at Henry Thornton.com.)